Saturday, April 1, 2017

I believe that one of the key benefits of a market economy is creative destruction. Entrepreneurship leads to innovation and growth. Profit and loss incentives motivate each firm to introduce new products and methods of production that create a system where larger amounts of better goods and services are produced. Successful innovation generates greater profit. Perhaps more important, innovation by competitors can result in reduced profits and perhaps losses and even bankruptcy. This creates a powerful incentive to innovate in order to "keep up with the competition."

A somewhat different consequence of profit and loss incentives is to allocate resources to produce whatever goods and services for which people are willing to pay the most. Competition for resources results in resource prices that communicate opportunity costs--the value of the most important goods and services sacrificed by the use of those resources in production. If buyers are willing to pay more for products than the opportunity cost of the resources used to produce them, then a firm profits. If, on the other hand, people are willing to pay less for a product than the opportunity cost, any firm producing that product suffers losses--motivating it to produce less. Profit and loss creates an incentive to produce more important things and avoid "wasting" resources in producing less important things.

But does any of this mean than capitalist economies must grow?

One "micro" argument would be that larger firms are always more efficient. This would seem to imply that only one firm can survive competition. During the competitive process, then, each firm is racing to be the biggest, and so most efficient, which will allow it to increase its lead and eventually "win" the competition by becoming a monopoly.

I am not sure how seriously to take such an argument. If a new production technique is introduced that exhibits economies of scale, and there were many firms using some prior approach with fewer such economies of scale, then something like the above process would occur. Depending on the economies of scale and the demand for the product, it could be that the result is a natural monopoly--a single firm can produce the amount of the product demanded at the lowest cost. But this is not necessarily true. It is not always most efficient to produce output in a single giant plant. It is more common to have many factories or plants even if they are all owned by a single firm. Having many factories managed by a single firm is not necessarily more efficient than having multiple independent firms in competition. Organizations have many problems, which generally are described as the cost of bureaucracy. One key benefit of the market system is that it allows for large scale cooperation without a single massive bureaucracy. There can instead be many, somewhat smaller, more manageable bureaucracies.

A second argument is "macro." Here there is a behavioral assumption that is supposed to be a defining characteristic of capitalism. Firms make profit. While the owners of the firms consume something, this can be ignored as a practical matter. The profits are all reinvested making the firm grow. "Capital," understood as the value of the firm, increases. "Capitalism" is an economic system that maximizes the growth of capital by maximizing profit. The greater capital is intended to result in greater profit and so greater increases in capital. Critics of capitalism claim that this system must eventually collapse. I read Marx as making an argument along these lines.

I think there are some advocates of the market system who defend it with something like the first part of the argument. They justify profit based upon how it is used. Profit is justified because it is reinvested and that creates more growth (and maybe even "more jobs.") I suppose for a leftist critic of capitalism, reading such claims by their opponents, gives them the impression that everyone agrees that capitalism entails constant growth in capital. And if these advocates of capitalism focus on the benefits of more capital and justify profit on that ground, then this explains their opposition to policies that reduce profit--such as higher wages.

I think that most economists, including those who are very sympathetic to the market, really don't focus on how profits might be used. As I mentioned in my first two paragraphs, the profits and losses both motivate innovation and also the allocation of resources to produce what particular goods and services people want to buy the most. If anything, the assumption is that the entrepreneurs use this source of income to enjoy greater consumption of goods and services. That is the reward they obtain for their successful innovation or reallocation of resources. I think allowing entrepreneurs to obtain profit and suffer losses is desirable because the prospect of profit and losses motivates them to do desirable things--innovate and reallocate resources to produce what people want to buy most.

Of course, entrepreneurs may well save part of the income they earn. Perhaps they will save a substantial portion of it. Still, any identification of profit with saving and capital accumulation is simply not a key element of modern economics. Instead, it is common to identify "capitalism" with a "market economy." My basic framing of the economic problem includes consumption being the purpose of production. So, as I consider capitalism, I don't start with profit and capital accumulation, must less with a "goal" of maximum aggregate profit and maximum accumulation of capital. Rather, it is about people achieving their goals, with an emphasis on producing the goods and services they most want to consume. Perhaps I have some slight idiosyncratic twist to my thinking on this, but I think it is pretty much consistent with mainstream economics. In my view, this is just a restatement of the centrality of scarcity in economic thinking.

Starting with this notion that the purpose of production is consumption helps make sense of the view that saving is about reducing consumption in the present and increasing it in the future. For an individual in a market system, to save is to spend less on consumer goods and services now than the income earned now, so that more can be spent on consumer goods and services later than the income earned later. Suppose someone works for many years and spends just part of their wage income on consumer goods and services. The saving each year is income less consumption. This person's wealth, or net worth, grows with that saving over the years. Eventually, this individual retires from work and no longer has any wage income. However, they continue to purchase consumer goods and services out of their accumulated wealth. Each year, wealth decreases due to dissaving. That is, consumption greater than income.

Entrepreneurs earn profit, which is a form of income. Unless they have some other source of income, they must use some of it to purchase consumer goods and services. If they earn a very high income, then they can purchase lots of consumer goods and services. However, like anyone else, they certainly can save. Still, the basic framing here is that they save by spending less income from profit on consumer goods and services now in order to spend more than their income in the future.

Under most circumstances, both the worker saving for retirement or the entrepreneur saving profit and building a fortune can earn capital income on their wealth. The worker might put savings in a bank and earn interest. The entrepreneur might reinvest his saving in his own firm, purchase additional capital equipment, and earn additional profit. This capital income reduces the amount the worker must save while working to have sufficient consumption when retired. The already luxurious consumption an entrepreneur could afford now is compounded in the future by the additional income earned on accumulated wealth.

However, this doesn't mean that there is some kind of "system" that has the goal of maximizing aggregate profit with all of it being saved to accumulate as much wealth as possible to increase profit as much as possible.

In my view, the fundamental reason for capital income is productivity. If fewer resources are used to produce consumer goods and services now, then those current resources can be used in ways that allow for additional production of consumer goods and services in the future that not only replace those sacrificed now, but exceed them. Generally these techniques involve the use of various sorts of durable tools--machinery, equipment and the like. More elaborate--more expensive and productive--tools can be used if more resources are available to produce them.

The capital income earned by the worker putting money in a bank for retirement or the entrepreneur reinvesting profit into his or her own enterprise captures part of this additional output as added income. That it is desirable that people earn capital income is not based on some notion that they will always reinvest such income and accumulate even more wealth which also implies that more valuable and productive capital equipment will be produced and utilized. Or rather, I don't think of it that way. It is rather that the prospect of earning such income in the first place motivates people to save more than they otherwise would, resulting in more total output and income than would otherwise exist.

To me, and most all economists, growth is about increases in the production of goods and services. It isn't about increases in aggregate profit or wealth or the capital stock. Profit and loss generates powerful incentives for growth, however, nothing in the market system, that is "capitalism," requires such growth. If no one was interested in any new good or service or there were no better ways to produce the existing ones, then there would be no more innovation. One of the key reasons why profit is desirable would no longer exist, though there would still be the second reason--producing the proper mix of existing goods and services in the already discovered most efficient ways.

Most economics is done in the context of a growing population. This requires some net saving and investment so that a growing work force can utilize the same types and amounts of capital equipment and that there will be more consumer goods and services for the additional people to enjoy. Such growth could occur with each person and generation enjoying unchanging consumption per capita. A market system could coordinate that scenario.

If the population were to be constant or even shrink, the market system could coordinate that scenario too. With a constant population, constant consumption and sufficient capital (tools and the like for each worker) could be maintained with no net saving or investment. With a shrinking population, the market system could coordinate a shrinking capital stock through negative saving and investment-net dissaving and net disinvestment. The output of consumer goods and services would shrink over time, reflecting the reality that there would be fewer people to enjoy them.

Or suppose people wanted to enjoy more leisure. They might prefer shorter workdays, work weeks, longer annual vacations, or perhaps start work later or retire earlier. If they valued this more than the goods and services that they would not be producing and could no longer afford, then the market system could coordinate that. Better yet, in the context of creative destruction and growing productivity it is perfectly possible to take the benefits in reduced work time. Further, a market system could coordinate a mixed result where more consumer goods and services are produced for people to enjoy along with additional leisure time to enjoy them.

If everyone wanted to consume all of their income, so that there was no net saving and no net investment, then wealth would not grow nor would the capital stock. However, if creative destruction continued, the capital equipment might well improve, and substantially change as old capital goods wear out and are replaced. Consumption could grow or leisure could expand without any increase in wealth or capital. (The scenario of no net saving or investment and a growing population is more challenging.)

Nothing in a market system requires constant growth in output. Nor does capitalism require that profits be saved and used to increase net worth and increase the capital stock.

A separate question is whether a practice of entrepreneurs always saving their profit so that profit always adds to net worth and the capital stock is harmful to the market system. It is not necessary for capitalism to exist, though it is plainly consistent with capitalism if people behave this way. What happens? Does that practice, which some seem to think is an essential defining characteristic of capitalism, have some calamitous consequence?